Funding Building, an Alternative to VC Investment for Innovation

On April 18th Marc Andreessen published his blog post IT’S TIME TO BUILD, expressing frustration with America’s lack of innovation outside of the software industry. In the post, Andreessen declared that the problem wasn’t a lack of ability or capital, instead:

The problem is desire. We need to *want* these things. The problem is inertia. We need to want these things more than we want to prevent these things. The problem is regulatory capture. We need to want new companies to build these things, even if incumbents don’t like it, even if only to force the incumbents to build these things. And the problem is will. We need to build these things.

Andreessen’s post received a lot of negative feedback on sites like Hacker News, some of which is justified and some of which isn’t, but Ben Thompson of Stratechery had my favorite response in his post How Tech Can Build. Thompson pointed out that Venture Capital’s love of software wasn’t just a reflection of abstract “desire” or the whims of investors, it was an inevitable bias of the VC model.

If you’re already familiar with the concepts of a section, feel free to skip it!

“VC Math” and why winners have to be huge

Because VCs invest in fledgling companies, they expect the vast majority of their investments to fail. This places pressure on the fund’s winning portfolio companies to not merely do “well” but instead do fantastically well. Companies need to grown 100–1000x or more in order for VCs to be successful. (The necessary multiples can seem absurdly high, but for a more in depth look and some examples of “VC Math”, consult this Tech Crunch Article).

Few companies can ever generate this kind of return, and almost all those that can are software companies. This is because software companies are able to serve their customers with near-zero marginal cost. Software is practically free to duplicate, and one piece of useful software can server thousands and millions and billions of people. Almost all the cost of building a software company will be in the initial investment, and then growth can be achieved cheaply. Companies with high margin are given high valuations relative to their profit or revenue. This is a perfect fit for the VC style of investing, and successful companies can grow enormously relative to their initial investment.

Conversely, most innovations in the physical world are subject to both high startup costs and high marginal costs. If VCs invested in more physical companies, their losers would be just as expensive as before, while their winners would have lower margins. Low margin businesses don’t get as high valuation multiples as high margin businesses, so the valuations are going to be smaller. VC as an asset class already has mediocre performance, investing in more physical companies would be suicide for most VC firms.

The call for a new model of investment

Subsequently, Thompson called for “… an investing model that is suited to outcomes that have a higher likelihood of success along with a lower upside.” If we want to fund innovation that requires high marginal cost, we have to defray the added marginal cost by lowering the risk inherent in all new startup companies.

Private Equity and avoiding “VC Math”

Luckily, there is already a popular asset class that fits that exact description, Private Equity. Private Equity (PE) funds raise a certain amount of capital from investors, then use that capital as a down payment to raise a much larger amount of debt and acquire a target company. This process is known as a Leveraged Buyout (LBO), and allows PE funds to invest in companies on a completely different scale than VC, ranging from the tens of millions to multiple billions. (For more about LBOs, this article is a good place to start. This Bloomberg article gives a nice overview of PE in general).

PE firms typically achieve this growth by investing in distressed companies. They acquire their target, then “streamline” by getting rid of underperforming business lines and cutting costs wherever possible. Proponents of PE funds will say that they are rescuing fundamentally good companies from collapsing under their own weight, while detractors will say that they hollow out companies, improve short term metrics, and then sell them off to someone else before the company sinks back into trouble.

Because PE funds invest in existing companies with existing business lines and revenue streams, fewer PE investments will be outright failures compared to VC investments. Combine that reduced risk with the benefits of leverage and PE funds require a much smaller return on their investment compared to VC, often only 2–4x growth of company valuation.

How could PE be done differently?

What if, instead of looking only at distressed companies, a PE fund looked for good-but-not-great companies in industries where all of the dominant players were behind technologically? This fund could acquire its good-but-not-great target and set about hiring a new, empowered technical team. This team would be responsible for building new software and new software-enabled processes that would increase the efficiency of the underlying business. These efficiencies could make the portfolio company more competitive in its space and allow it to invest in new growth opportunities.

What makes this model different? Why isn’t it being done already?

This model is difficult to pull off because it exists in the cultural blind spots of both PE and Silicon Valley. In PE, the vast majority of professionals in the space have a background in finance. They are focused on creating value by reorganization and financial optimization. In Silicon Valley, it is well known amongst engineers and technology leaders that working for non-tech companies is a bad idea. Non-tech companies almost always treat their internal software teams as cost centers, and as such they provide low pay and low respect to the engineering organization. To make matters worse, this tends to create a self-fulfilling prophecy where only mediocre engineers would choose to work there, further alienating talented engineers from ever joining such a company. This leaves many industries starved of innovation.

In our new model, engineering is a core competency of the fund itself! The fund would have talented technologists on the management team from the beginning. They would ensure that portfolio companies’ engineering teams have the authority necessary to implement new processes, and the budget necessary to hire talented enough engineers capable of actually doing it. Portfolio companies would be given an asset that is not only valuable, but also incredibly difficult for industry competitors to replicate as they don’t have the ability to hire and lead engineering teams.

Furthermore this model would potentially give access to even better engineers than most startups! Startups have a notoriously hard time recruiting engineers because they simply can’t offer anything close to the compensation offered by big tech companies. Under this new model, portfolio companies have access to large amounts of capital from the fund, and can afford to pay competitively with big tech. This is especially valuable for the initial team of engineers and engineering leaders who would form the crucial core of the portfolio company’s new technical team.

TL,DR

The fundamental insight is this: VC cannot invest in high marginal cost businesses as the risk of failure in new ventures is too high to justify the lower rate of return. But what we really care about is innovation, not specifically innovation from new companies. A PE fund with technology as a core competency could acquire companies in technologically backward industries, then create and empower engineering teams capable of innovating in said industries.

Stay tuned for a followup article, where I discuss why VC may be poorly positioned for the coming decade